Much success in financial innovation is due to coming up with a sexy name; “dark pool” just grabs the imagination more than “alternative trading system with undisplayed orders.” The downside, though, is that it also seems to have grabbed the SEC’s imagination, which I suspect is part of the explanation for the SEC’s rather odd enforcement action against horribly capitalized eBX, LLC’s horribly capitalized dark pool LeveL.
Here is my effort to understand it:
- eBX is a company that runs a dark pool named LeveL.
- As far as I can tell “runs a dark pool” means (1) wrote a computer program to match buy and sell orders without displaying those orders to anyone else (thus, “dark”) and (2) runs around convincing people to route their orders to that computer program.
- LeveL contracted with Lava to run LeveL’s computer program on Lava’s servers.
- LeveL also contracted with Lava to be the gateway to it.1
- So basically if you wanted to buy a share of GS at $125, that order would go into a Lava router computer, which would then send it to the Lava matching engine computer.
- If there was a GS sell order in the matching engine at $125, you’d buy GS; if not, your order would sit there and wait for a sell order.
- Lava, separately, ran a “smart router” where its clients could submit orders to sell GS at $125, and Lava would route those orders to the exchange that had orders to buy GS at $125.
- Lava convinced LeveL to allow it to “remember” what orders went through the LeveL router, so that when its smart-router clients used the smart router, it could be smart: it routed orders to places that had contra side orders. So if someone placed a sell order on LeveL, and the Lava smart router later got a buy order on the same stock and a matching price, Lava would route the order to LeveL; if there was no such sell order it wouldn’t.
- But LeveL was telling clients that it couldn’t use their orders for any purposes other than matching them; as the SEC’s order says, “most LeveL subscribers were not provided with the additional information that their unexecuted order data was being remembered by the Memory Feature and was being used to make order routing decisions for customers of the Order Routing Business.”
So many questions. First: did this hurt anyone? One thing to think is “if it did, surely the SEC would tell us about it,” and they … sort of didn’t. Robert Khuzami, who still cannot resist a chance to say things like this, said this thing:
“Dark pools are dark for a reason: buyers and sellers expect confidentiality of their trading information,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “Many eBX subscribers didn’t get the benefit of that bargain – they were unaware that another order routing system was given exclusive access to trading information that it used for its own benefit.”
What is the benefit of that bargain? Or, what reason is the reason that dark pools are dark for? I don’t think that people “expect confidentiality of their trading information” for the same reason that they expect confidentiality of their Facebook messages, viz. that their trading information is evidence of continued pining for their high school crushes. They expect confidentiality of their trading information because they don’t want that trading information to be used to front-run them. Dark pools are dark because orders are only supposed to be used for anonymous matching with other orders, not for display to people who will trade against them.
Here it at least appears that the information was only used for anonymous matching: once Lava had an order, it used remembered LeveL data to decide whether or not to route that order in to LeveL. But it couldn’t, for instance, tell clients “oh you should buy lots of GS stock because there’s a big buy order on LeveL that will push up the price” – all it did was anonymous matching; it just did the anonymous matching on the deck of the LeveL dark pool instead of in the pool itself. As the SEC says:
There is no evidence that information about LeveL’s unexecuted orders was displayed, or otherwise communicated to, clients of the Order Routing Business [Lava] or other third parties.
Second question: why do this? Basically I imagine Lava as having a room, and in that room there is a computer called the Smart Router, and another computer called the LeveL Matching Engine. An order comes in and goes to the Smart Router. The Smart Router can either:
- send the order across the room to the LeveL Matching Engine, see if there’s a contra side order in the Matching Engine’s memory that will fill it, and if it’s not, send it on to another exchange, or
- check its own memory to see if there’s a contra side order in LeveL that will fill it, send it across the room to LeveL if there is, and send it to another exchange if there isn’t.
In other words as far as I can tell this illegal procedure saved Lava’s data a trip across the room. Why bother? One possible answer is some sort of speed or bandwidth optimization – it takes time to cross that room, and you want to save time. I suppose another answer is that you can parallel rather than serial process; if your Smart Router knows the displayed prices at ten venues you can send to the best venue rather than starting blind with LeveL and going from there.
Does that hurt or help LeveL customers? Probably not much of either. I suppose in the absence of data a smart router would (1) see what displayed levels are elsewhere, (2) route a fill-or-kill order to LeveL with a limit (for a buy order) of min(customer’s limit, best price elsewhere), and see if it fills. With the memory data, it would … effectively do the same? Here is the SEC’s order, paragraph 27:
While the record shows that the actual execution price received by the LeveL subscriber and the Order Routing Business [Lava] would be identical to the execution price that would have resulted had the Order Routing Business sent the same orders to LeveL without the benefit of the Memory Feature, knowledge of the pricing information of orders resting in LeveL gave the Order Routing Business the ability to route orders to LeveL in situations where the resulting price could have been better for the Order Routing Business’ customer than prices available in other market centers.
Should we care? Even without memory, Lava could always have routed orders to LeveL with a limit of “best price available in other market centers,” see if they fill, and if not move on to other market centers, so all Lava seems to save here is the room-crossing time. And LeveL subscribers seem to get the same execution price, unless the SEC and I are missing something. Which is … not impossible. (Tell us what we’re missing!2)
Third question is of course: why does the SEC care? There’s some argument that violating any terms of any agreement is Bad and you Shouldn’t Do It, of course, but the SEC is not in the business of enforcing all agreements; what is their vision of the need for enforcement here? My model of the SEC’s high-frequency-trading regulation continues to be basically “talk loudly about scary-sounding things while having as little impact as possible,” and the facts here seem to fit that model perfectly: nothing really happened here, but it gave the SEC an opportunity to clip a fine and issue a press release about DARK POOLS.
1. Lava’s not named in the SEC order, but eBX told the Journal it was them, and that seems to have been widely disseminated. The fact that they ran both the router and the matching engine was also widely disclosed; from paragraph 42 of the SEC’s order:
LeveL … disclose[d] that the Service Provider [i.e. Lava] provided “Technology Services” to LeveL, including the “technology related to the ATS matching system” and “all implementation, hosting, maintenance services” that are “necessary to access and use the Matching Application for eBX’s operations and maintain the operating capability of the Matching Application.”
So LeveL seems to have told everyone that its matching engine was actually running on Lava computers.